When it comes to mergers and acquisitions, private equity firms are in high-stakes competition with public companies to identify takeover targets. During some M&A waves, public companies dominate while in other periods private equity firms win out.

Understanding why is a vital yet relatively understudied subject of business research. After all, the economic activity generated by these deals is huge—North American M&A deals in 2011 were estimated at $450 billion. But another reason, says Harvard Business School’s Matthew Rhodes-Kropf, is that the shifting balance of power between private equity and public companies “changes the ownership structure of assets and alters the incentives and governance mechanisms that surround the economic engine of our economy.”

During a recent interview, Rhodes-Kropf, an associate professor in the Entrepreneurial Management Unit, said his research with Marc Martos-Vila (UCLA Anderson School of Management), and Jarrad Harford (University of Washington) revealed unexpected theories about when and why companies merge or acquire other firms—and how perception of the debt market impacts these deals. The results were published in the paper, Financial vs. Strategic Buyers.

The research team first scoured data of private equity firms in the United States that had set out to buy underperforming companies and turn them around—with the goal of a strong return on investment. They then compared that data to M&A within public companies that acquire or merge with other companies as part of a longer-term business strategy. Altogether, the researchers mined M&A activity of all public targets with a value of less than $1 billion between 1984 and 2010.

Competition between companies

Past academic M&A research examined topics such as how structured credit impacted the buyout boom and bidding strategies of private equity firms, but little focus had been placed on the competition between acquiring companies themselves.

In earlier research Rhodes-Kropf had theorized that overvalued acquiring companies would bid more for an acquisition target than would undervalued acquirers—and that overvalued targets would be more willing to accept takeover offers, leading to waves of M&A activity during a market bubble. Peaks of activity for financial (PE firms) and strategic (public companies) acquirers corresponded with the stock market peaks such as in the late 1990s and 2006-2007, with dips during recessions in the early 1990s and 2001.

What influenced M&A in different time periods during spikes and dips is under debate. Previous research showed that interest rates, specifically the spread between the average interest rate on commercial and industrial loans and the federal funds rate, moved in opposite directions with merger activity. This spread, the researcher argued, enabled more M&A liquidity and easier financing.

But the reality wasn’t that simple. “We pointed out that there are waves: during one year private equity dominates, the next year strategic companies dominate,” Rhodes-Kropf says. “It makes you think there’s a driver.”

The researchers’ data suggested that something else was at work within these M&A spikes and dips—what Rhodes-Kropf terms “debt market misvaluation,” the idea that debt can be misvalued, just as stocks can be misvalued.

“There’s a lot of empirical evidence that equity misvaluations were driving merger waves and that being overvalued makes a company a target, but what is the effect of misvalued debt?”

The paper explores how the possibility of misvalued debt markets can both fuel merger activity and alter the balance between PE and strategic buyers.

One approach was to study whether “cheap” debt led to more acquisition activity and whether debt market misvaluation altered the interplay between financial and strategic buyers. “Just believing that debt markets are overvalued does not imply a benefit to one type of buyer,” says Rhodes-Kropf.

Rhodes-Kropf says that debt market misvaluation works with what is called a co-insurance effect, and the outcome is different for private equity firms and strategic companies.

With this effect, a strategic company financing multiple long-term projects won’t be as drawn to take advantage of cheap debt just because it’s available, for the reason that it will still have to pay the money back. But a financial firm can leverage cheap debt “massively,” Rhodes-Kropf says, because it does deals one at a time and is willing to walk away from the debt and return the company to the debt holders. (Strategic companies also have a different corporate governance structure than financial firms.)

“It will work out or it won’t,” he says. “If it doesn’t, private equity investors can walk away.”

Factoring in co-insurance

Rhodes-Kropf says a co-insurance effect combined with debt market misvaluation plays out in different ways. A strategic company is less likely to default on a debt when the two firms’ assets and liabilities are combined through a merger or acquisition (the opposite is true when a financial firm makes these deals). According to the co-insurance theory, combined debt is safer and should reduce the yield investors demand from the company’s bonds.

Even though both strategic and financial buyers would like to take advantage of interest rates that are “too low” and avoid borrowing when interest rates are “too high” they are impacted differently by the errors—and are willing to pay relatively more or less depending on the error made on interest rates.

The magnitude of the co-insurance effect for a company depends on the probability that either of two interdependent projects in a strategic company has a bad outcome. When debt holders underestimate the probability of a bad outcome they both overvalue the debt and undervalue the co-insurance effect. At these times, strategic companies suffer relative to private equity firms.

Alternatively, when debt investors overestimate the probability of a bad outcome they both undervalue the debt and overvalue the co-insurance effect of combining projects. In these cases, financial acquirers on average cannot pay as much as strategic acquirers.

Debt misvaluation and the future

Rhodes-Kropf says he expects that debt misvaluation will help private equity firms dominate over strategic companies in mergers and acquisitions in the future. The reason? When debt markets are misvalued, private equity firms will be able to leverage more and extract more value from the project than a strategic acquirer, or firms that operate on a stand-alone basis. He hopes that future research will confirm their new debt misvaluation findings.

Rhodes-Kropf’s latest work in M&A focuses on firms that “merge into the fast lane.” His preliminary work shows that firms move from industries that were valued more highly in the past into industries where firms will be valued more highly in the future. This finding suggests that M&A activity is about a management team looking for a new activity and leads to questions about the definition of a firm.